Chipotle Mexican Grill (CMG) is one of the fastest growing restaurant chains in the United States. Self proclaimed as “fast-casual,” CMG offers a dining experience that is unique, organic, and which draws from the local economy. For the investor, CMG is a wise investment for the aggressive and fast growing portion of a portfolio. When determining an appropriate model to evaluate CMG’s potential, the Capital Asset Pricing Model (CAPM) is the best choice. This model offers the best amount detail while maintaining the simplicity needed for a model outlining investment decisions in CMG.

The Pricing Models

There are three pricing models to discuss when evaluating CMG: dividend growth, CAPM, and the Arbitrage Pricing Theory (APT). Each of these models has both advantages and disadvantages, easily tailoring one model to different situations. However, the CAPM is best suited for this case with CMG. Below is a further review on each of models’ advantages and disadvantages, and applicability to CMG’s market position and financial situation.

The Gordon Growth Model

The Gordon Growth Model (GGM) is a very simple model for estimating the value of a stock. This equation works by calculating the stock value from dividends per share, the required rate of return for the equity investor, and growth rate in dividends (Gordon, 2008). The equation looks like this: Stock Value (P) = D / (k-G). Where D is the expected dividend per share one year from now, k is the required rate of return for the equity investor, and G is the growth rate in perpetuity. This dividend growth model is best suited for a firm growing at a rate comparable to or lower than the nominal growth rate in the economy and which have well established dividend payout policies that they intend to continue in the future (Dividend). In addition, the dividend growth model is also suited for businesses that are in a stable market (Dividend). A good example of this type of company could be 3M or General Electric. Both of these companies are stable and have a steady growth rate. Moreover, these two companies are subject to various regulations and restrictions from multiple government agencies that also have a factor in limiting the growth of the corporation.

The GGM is not the preferred analysis tool for CMG for a few reasons. First, CMG has only been a public company for almost six years. This does not give enough data points to convince the investor on the direction of the company. The investor is unable to judge what CMG will do in the near and long-term regarding the growth of the company. Currently, CMG has a very high growth rate. CMG is adding over 130 restaurant locations in 2010 alone, not to mention beginning business ventures in the international market (Annual, 2009). This high growth rate deters the wise investor from using the GGM to analyze CMG. Lastly, CMG is not in a market regulated on the rate of company growth. CMG can legally build as many new restaurants that are humanly possible (fair financial practices assumed). The high growth rate that CMG has creates a mathematical problem for the GGM because it will drive the price exponentially higher. This also invalidates the accuracy of the assessment and drives the investor to use a different tool.

The Arbitrage Pricing Theory

The Arbitrage Pricing Theory (APT) also is not the right choice for CMG, though it came in close second place. The APT works by calculating the expected return of an asset with the following equation: E[Ra] = R f + ß a(E[Rm] - R f). In this equation, E[Ra] is the expected return of the investment, Rf is the risk free rate, ß a is the beta of the investment, and E[Rm] is the expected return on the market. Furthermore, this theory produces another equation: r = rf + β1f1 + β2f2...

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...A Chartered Financial Analyst, Jeffrey Bruner, uses the CapitalAssetPricingModel (CAPM) to help identify mispriced securities. However, a consultant suggests Bruner to use Arbitrage Pricing Theory (APT) instead. As the following, it will mention the role of CAPM in the modern portfolio management; to clarify the APT faction and explain the reasons why should Bruner use APT to help identify mispriced securities.
In modern portfolio management, the role of CapitalAssetPricingModel (CAPM) is a model that attempts to describe the relationship between the risk and the expected return on an investment and that is used in the pricing of risky securities. The assumption behind the CAPM is that there is only one risk-free rate in the model, investors can borrow and lend unlimited amounts under the risk rate of interest; the perfect information is freely available to all investors who, as a result, have the same expectations; that all investors are risk averse, rational and desire to maximise their own utility; and the capital market is characterised by perfect competition, there are broadly diversified across a range of investments and the investors will only require a return for the systematic risk of their portfolio, since unsystematic risk has been removed and can ignored. It also assumes...

...individual assets held in combination. An asset that would be relatively risky if held in isolation may have little, or even no risk if held in a well-diversified portfolio.
b. The feasible, or attainable, set represents all portfolios that can be constructed from a given set of stocks. This set is only efficient for part of its combinations.
c. An efficient portfolio is that portfolio which provides the highest expected return for any degree of risk. Alternatively, the efficient portfolio is that which provides the lowest degree of risk for any expected return.
d. The efficient frontier is the set of efficient portfolios out of the full set of potential portfolios. On a graph, the efficient frontier constitutes the boundary line of the set of potential portfolios.
e. An indifference curve is the risk/return trade-off function for a particular investor and reflects that investor's attitude toward risk. The indifference curve specifies an investor's required rate of return for a given level of risk. The greater the slope of the indifference curve, the greater is the investor's risk aversion.
f. The optimal portfolio for an investor is the point at which the efficient set of portfolios--the efficient frontier--is just tangent to the investor's indifference curve. This point marks the highest level of satisfaction an investor can attain given the set of potential portfolios.
g. The CapitalAsset...

...1. For each of the scenarios below, explain whether or not it represents a diversifiable or an undiversifiable risk. Please consider the issues from the viewpoint of investors. Explain your reasoning
Undiversifiable (market )risk:
Market risk is the variability in all risky assets caused by macroeconomic variables. This risk cannot be avoided, regardless of the amount of diversification. Systematic risk (Market risk) factors are those macroeconomic variables that affect the valuation of all risky assets such as variability in the growth of the money supply, interest rate volatility, variability in aggregate industrial production, and natural shocks like drought, earth quake, hurricane, etc.
Diversifiable (unique )risk:
Many of the risks faced by an individual company are peculiar to its activity, its management, etc. These are the unique risks and can be diversified away. Examples of unique risks are a company winning a large contract, wildcat strikes hitting a company, litigation hitting a company or the company facing a governmental investigation.
a. A large fire severely damages three major U.S. cities.
Diversifiable risk
The entire economy will not be affected by a large fire in three major US cities. In fact some companies in cities not affected by fire will benefit as they will meet the demand not being met by companies in the three cities that are...

...Chapter 9: Multifactor Models of Risk and Return. (QUESTIONS)
1. Both the capitalassetpricingmodel and the arbitrage pricing theory rely on the proposition that a no-risk, no-wealth investment should earn, on average, no return. Explain why this should be the case, being sure to describe briefly the similarities and differences between CAPM and APT. Also, using either of these theories, explain how superior investment performance can be establish.
Answer:
Both the CapitalAssetPricingModel and the Arbitrage PricingModel rest on the assumption that investors are reward with non-zero return for undertaking two activities:
(1) committing capital (non-zero investment); and (2) taking risk. If an investor could earn a positive return for no investment and no risk, then it should be possible for all investors to do the same. This would eliminate the source of the “something for nothing” return.
In either model, superior performance relative to a benchmark would be found by positive excess returns as measured by a statistically significant positive constant term, or alpha. This would be the return not explained by the variables in the model.
2. You are the lead manager of a large mutual fund. You have become aware that several equity analysts who have...

... explain whether or not it represents a diversifiable or an undiversifiable risk. Please consider the issues from the viewpoint of investors. Explain your reasoning
a. There's a substantial unexpected increase in inflation.
b. There's a major recession in the U.S.
c. A major lawsuit is filed against one large publicly traded corporation.
2. Use the CAPM to answer the following questions:
a. Find the Expected Rate of Return on the Market Portfolio given that the Expected Rate of Return on Asset "i" is 12%, the Risk-Free Rate is 4%, and the Beta (b) for Asset "i" is 1.2.
b. Find the Risk-Free Rate given that the Expected Rate of Return on Asset "j" is 9%, the Expected Return on the Market Portfolio is 10%, and the Beta (b) for Asset "j" is 0.8.
c. What do you think the Beta (β) of your portfolio would be if you owned half of all the stocks traded on the major exchanges? Explain.
3. In one page explain what you think is the main 'message' of the CapitalAssetPricingModel to corporations and what is the main message of the CAPM to investors?
1. For each of the scenarios below, explain whether or not it represents a diversifiable or an un-diversifiable risk. Please consider the issues from the viewpoint of investors. Explain your reasoning
a. There’s a substantial unexpected increase in inflation.
Un-diversifiable risk
The entire...

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CHAPTER 24
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Portfolio Theory, AssetPricingModels, and Behavioral Finance
Please see the preface for information on the AACSB letter indicators (F, M, etc.) on the subject lines.
True/False
Easy:
(24.4) SML FN Answer: b EASY
. The slope of the SML is determined by the value of beta.
a. True
b. False
(24.4) SML FN Answer: a EASY
. If you plotted the returns of Selleck & Company against those of the market and found that the slope of your line was negative, the CAPM would indicate that the required rate of return on Selleck’s stock should be less than the risk-free rate for a well-diversified investor, assuming that the observed relationship is expected to continue in the future.
a. True
b. False
(24.5) Beta coefficient FN Answer: a EASY
. If the returns of two firms are negatively correlated, then one of them must have a negative beta.
a. True
b. False
(24.5) Beta coefficient FN Answer: b EASY
. A stock with a beta equal to -1.0 has zero systematic (or market) risk.
a. True
b. False
(24.5)...

...Introduction
Capitalassetpricingmodel (CAPM) is regarded as a superior model of security price behavior to others based on wealth maximization criteria. CAPM explicitly identifies the risk associated with an ordinary share as well as the future returns it is expected to generate. Until recent the empirical tests supported CAPM, but a test by Fama and French in 1992 did not, stating that it is useless for the precisely what it was developed for. Following the criticism of the model questions such as whether to abandon the model and develop a new one arose.
In this essay I will describe the model and describe the researchers test, which justify the usefulness of the model.
Main concepts behind the problem and discussion
The CAPM was developed by Sharpe (1963) as a logical extension to the basic portfolio theory, followed by numerous academics, notably Lintner (1965). The model was developed to explain the difference in risk premium across assets. According to the model this differences are due to the differences in the riskiness of the expected returns. The model affirmers that the correct measure of risk is beta and that the risk premium of riskiness is same across all assets. Given the beta and the risk free rate, the model predicts the expected...